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Option 2 : Raising the reserve requirement for banks
The Correct Answer is Raising the reserve requirement for banks.
- Contractionary monetary policy is a macroeconomic tool that a central bank — in the US, that's the Federal Reserve — uses to reduce inflation.
- The goal is to slow the pace of the economy by reducing the money supply, or the amount of cash and readily cashable funds circulating throughout the nation. It is the opposite of expansionary monetary policy.
- Governments and central banks believe a small level of inflation is good because it spurs demand. If consumers believe that goods and services will be more expensive in the future due to increased prices, they will buy those goods and services in the present. And of course, as per the law of supply and demand, the more they buy, the more businesses must produce. That means businesses need more workers, which means increased employment, which means more disposable income to buy goods and services, which further increases demand and prices.
- The problem arises when there is too much demand in the present. If businesses cannot produce more, or their production costs increase too much, then they raise prices. Things start to cost more than their intrinsic worth, and if prices get too high, it eventually chokes off demand — because people can't afford to buy anymore.
- And if businesses over-expanded in an effort to keep up with demand, they'll be in trouble when demand dries up.
- The purpose of contractionary monetary policy is to prevent these rude shocks from happening. To slow down economic growth, the central bank must curb demand by making goods and services more expensive to buy — at least for a while.
- Contractionary monetary policy consists of three major tools:
- Increasing interest rates
- Selling government securities
- Raising the reserve requirement for banks (the amount of cash they must keep handy)
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